Putting a Price on Carbon: a Handbook for U.S

WORKING PAPER PUTTING A PRICE ON CARBON: A HANDBOOK FOR U.S. POLICYMAKERS KEVIN KENNEDY, MICHAEL OBEITER, AND NOAH KAUFMAN EXECUTIVE SUMMARY Putting a Price on Carbon: A Handbook for U.S. CONTENTS Policymakers is the first in a series of papers that the Executive Summary....................................................... 1 World Resources Institute will produce with the aim of 1. Introduction............................................................... 6 providing a clear and comprehensive understanding of 2. Basics of Pricing Carbon...........................................7 the key issues that will need to be addressed if the United States ultimately imposes a national price on carbon. The 3. A Brief History of Carbon Pricing............................12 Handbook lays out what is already known about the design 4. Key Design Features.................................................17 and effects of different approaches to pricing carbon, with a 5. Commonly Proposed Uses of focus on carbon taxes and cap-and-trade programs. Carbon Pricing Revenues.........................................24 We believe that pricing carbon should be a core element 6. Economic Effects of a Carbon Price.........................34 of the United States’ long-term strategy for achieving 7. Conclusion.............................................................. 40 significant reductions in greenhouse gas emissions in the Appendix......................................................................42 coming decades. However, in writing the Handbook, we recognize that many who are, or could become, interested Bibliography.................................................................45 in carbon pricing might be motivated by the potential Endnotes......................................................................48 for benefits that are unrelated to climate change. Carbon price programs can be designed with an eye toward other possible policy goals, such as reforming the tax code to be Working Papers contain preliminary research, analysis, more efficient. Even when carbon pricing is approached findings, and recommendations. They are circulated to with non-climate priorities in mind, the emission reduc- stimulate timely discussion and critical feedback and tion potential provides an insurance policy against the risk to influence ongoing debate on emerging issues. Most of significant climate impacts. working papers are eventually published in another form and their content may be revised. The Handbook provides an overview of carbon pricing— the types of decisions that need to be made in designing a Suggested Citation: Kennedy, K., M. Obeiter, and N. program (including the political decisions about the use of Kaufman. 2015. “Putting a Price on Carbon: A Handbook for U.S. revenue) and the expected economic impacts of alternative Policymakers.” Working Paper. Washington, DC: World Resources approaches. We conducted a thorough review of the Institute. Available online at http://wri.org/carbonpricing. literature, selecting a broad array of well-regarded and highly cited studies that represent a range of viewpoints. We expect this Handbook to be useful in the public debate in the United States on whether, how, and when to implement a national carbon price. WORKING PAPER | April 2015 | 1 The Basics of Pricing Carbon In California, some money from the cap-and-trade allowance auctions is returned to electricity custom- Greenhouse gas emissions impose costs on the global ers in the form of rebates on their bills. These types of community via climate change. A carbon price shifts the approaches could also ensure that low-income house- burden of these costs from society as a whole to the enti- holds receive at least as much in income as they spend ties responsible for the emissions, providing an incentive on the tax. to decrease carbon emissions. DEFICIT REDUCTION. Large national deficits can reduce Pricing carbon increases the prices of goods across the ▪ economic growth rates by increasing interest rates, economy in proportion to their carbon content, and thus inhibiting (or “crowding out”) private sector invest- in proportion to their effect on climate change. By raising ments, and increasing future tax burdens to pay off the relative price of carbon-intensive goods (for example, the principal or interest on the debt. Carbon pricing fossil fuels), a carbon price encourages individuals and revenues could be used to reduce annual deficits and businesses to purchase less carbon-intensive alternatives. thereby help to avoid such adverse economic effects. A carbon price would lead to reductions in U.S. green- INVESTING IN COMBATING CLIMATE CHANGE. In addition house gas emissions and create leverage to encourage ▪ to its potential to stimulate innovation in low-carbon other countries to reduce their emissions, both of which technologies (for example, renewable energy), a are necessary to prevent the more severe effects of climate carbon price can provide revenue to help promote the change. In addition, reduced fossil fuel usage will provide development and deployment of breakthrough tech- “co-benefits” in the form of reduced emissions of other nologies. In addition, carbon-pricing revenues can be harmful air pollutants. used to invest in infrastructure that helps communi- While pricing carbon implies higher prices for certain ties adapt to the effects of climate change that are now goods, the additional costs to individuals and businesses unavoidable (extreme weather, sea level rise, etc.). become an additional source of revenue that can either TRANSITIONAL ASSISTANCE. A portion of the revenues be returned to households or spent in other productive ▪ can be used to assist those likely to be most adversely ways. Among other possibilities, carbon-pricing revenues affected by a carbon price. Job training can be provided can be used to promote economic growth, advance low- to workers in industries with anticipated job losses carbon technologies and other activities that help respond (for example, coal mining). In addition, revenues can to climate change, and reduce adverse economic effects of be disproportionately allocated to households and the carbon price. business in regions of the country that are most heav- The following are some of the specific potential uses of ily dependent on the production or consumption of carbon pricing revenues: fossil fuels in order to smooth the transition to a lower carbon economy. Revenues can also be used to pro- TAX CUTS. The revenues from carbon pricing could be vide assistance to industries that might face increased ▪ used to fund cuts in other tax rates. Taxes on labor competition from foreign competitors. and capital can reduce the income of individuals and businesses and decrease incentives to engage in Many other ways are available to make use of carbon- productive activities such as work and investment. pricing revenue. While many advocates strongly favor Such taxes differ from a carbon tax, which corrects one or another particular approach to the use of revenue, for a market failure and reduces the incentive to emit existing or proposed carbon-pricing policies often include harmful greenhouse gases. a mixture of approaches in accordance with the compro- mises and trade-offs required to pass such far-reaching RETURNING MONEY TO HOUSEHOLDS OR ELECTRICITY legislation. ▪ CONSUMERS. Revenue from carbon pricing could be returned to households by sending them “lump sum” Carbon Taxes versus Cap-and-Trade payments, which could be divided equally or by some This Handbook focuses on the two main approaches to alternative metric. This “tax-and-dividend” approach pricing carbon: carbon taxes and cap-and-trade programs. has gained popularity largely because of its perceived A carbon tax is a fee added to the price of goods in propor- fairness and simplicity. Households could be provided tion to their carbon content. A cap-and-trade program with tax refunds or sent quarterly or annual checks. 2 | Putting a Price on Carbon: A Handbook for U.S. Policymakers entails setting a maximum level of carbon emissions, with Program provided proof of concept for cap and trade, emissions allowances issued by regulators up to this cap which has since been used for pricing carbon. that can be bought or sold. Under a cap-and-trade program, the carbon price is equal to the market price of the The European Union established its Emissions Trading Scheme in 2005, which is the world’s largest CO cap-and- emissions allowances. 2 trade program.3 The EU-ETS went through a rocky initial If properly designed and implemented, both carbon taxes phase, which saw prices collapse due, in part, to the over- and cap-and-trade programs provide incentives to under- allocation of allowances. However, the program has since take the lowest cost abatement opportunities (those less achieved a stable market for allowances and meaningful expensive than paying the carbon price). In addition, car- emissions reductions, and has provided useful lessons for bon taxes and cap-and-trade programs require a number other cap-and-trade programs developed elsewhere. of similar decisions to be made in the design process. Back in the United States, starting with the Climate While the effects of comparably stringent carbon taxes and Stewardship Act of 2003, Congress has seen numerous cap-and-trade programs are virtually identical in theory, carbon pricing proposals, many with bipartisan sponsor- a number of practical differences exist between the two ship and support. The 111th

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